Today’s environment underscores the need for risk-based loan pricing
By Steve Cocheo, executive editor,
This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
All lending entails risk. Risk-based pricing hinges on competition, opportunity, environment, and customers’ satisfaction
AN ABA BANKING JOURNAL ROUNDTABLE
Kentucky banker Billie Wade tells this story about a fellow lender whose bank, in Lexington—race horse country—had an exam recently.
Out-of-area examiners “came in with a little bit of a tainted eye,” said Wade.
“They asked him,‘80% of your loans are backed by real estate. Doesn’t that concern you?’,” says Wade. “My friend answered, ‘What would you rather my loans be backed by? Thoroughbred horses?’”
Wade explains that in his part of Kentucky lenders may take horses as additional collateral on a deal, but not as the primary security. Instead, they tend to rely on farm real estate. Land, which doesn’t eat, move around, break legs, get sick, or die, seems a less-risky form of collateral.
Risk, and managing it, is something bankers and examiners rarely concur on 100%. Of course, as current conditions illustrate, even a “sure thing” like land isn’t necessarily anything ironclad. Yet all lending includes an element of risk. And when done right, it involves judgment, and timing, and market understanding.
Wade, president and CEO of $689.1 million-assets Citizens Union Bank, Shelbyville, said his banking friend was somewhat amused by the examiners’ views. For his part, Wade felt that “I’d much rather collect on real estate collateral than try to collect on accounts receivable, or machinery.” (Or horses.)
Getting credit risk right—and priced right—were key points of a recent roundtable discussion conducted among members of the ABA America’s Community Bankers Council. This discussion took place in an environment that defies generalization, in spite of what some would say.
Lending conditions, CRE and beyond
Community bankers face a period of conflicting signals. Washington wants to see more lending to small business, a point made by the President in two different banker meetings in December, one spun as a back-of-the-woodshed session for large institutions, and one as a friendlier session for community bankers.
Yet this is a limited, one-sided viewpoint. In a January speech, former community banker and Federal Reserve board member Elizabeth “Betsy” Duke spoke of this perception and the reality.
“The reduction in the availability of credit, however, is not the whole story,” Duke stated. “There is also less demand for credit. As businesses reduced inventory levels and capital spending, they tended to pay down debt and build cash positions.
Loan growth is very much a matter of the markets a bank serves today, the roundtable members noted.
For instance, take the case of Stewart McClure’s Somerset Hills Bank, in Bernardsville, N.J.
The $320 million-asset bank’s markets are about 40 miles away from Manhattan.
“Our loan demand hasn’t been that strong,” said McClure, president and CEO. “We’ve seen pretty much everybody who can pay off do so. There has been a lot of de-leveraging.” McClure explains that his market is affluent, with many lawyers, doctors, and accountants who remain profitably employed but who have chosen to trim debt and avoid more of it.
In addition, McClure’s bank became much choosier about commercial real estate, beginning a few years back. This policy shift especially affected construction lending.
“We began seeing people building $5, $6 million houses on the sides of mountains,” said McClure. “When things were strong enough, we certainly participated in that, but it started to get crazy, to us. You begin to see these things coming. So we started backing off.”
Further south, “loan demand is better than it was six months ago, but nowhere near where it needs to be,” said Patti Steele, president and CEO, at $630.7 million-assets First Volunteer Bank of Tennessee, Chattanooga. Steele’s bank serves multi-county markets through 25 branches.
“We’re up almost 8% year over year, on both the lending and deposit side,” said Randy Ferrell, president and CEO at Fauquier Bank, Warrenton, Va. Ferrell said that the $548.2 million-assets institution has watched major regional banks such as PNC and BB&T exit his bank’s markets.
“As a result, we’ve been able to pick up some very good, creditworthy customers on the commercial side,” said Ferrell.
Turbulence in sky hits aircraft makers
“Competition’s pretty fierce for good loans,” said Frank Carson, president and CEO of $81.3 million-assets Carson Bank, Mulvane, Kan. Carson noted that in his market, just south of Wichita in south central Kansas, business conditions, somewhat insulated from other parts of the country, nosedived when Washington declared war on corporate jets.
“Our aircraft industry just shut off when President Obama said that nobody could fly planes anymore,” said Carson. “Within weeks, we saw an industry that had backlogged orders—running up to five years—become decimated. So now we’re living with the kinds of conditions that many other bankers have been living with for the last couple of years.”
Carson said Kansas banks also have had their troubles as a result of investments in loan participations. Because the state was historically a unit banking jurisdiction, he explained, the banks tend to be smaller, with corresponding loan limits. Institutions with participations have had the greatest problems, said Carson. His own bank was coming off a year of rebuilding from a significant participation.
“We all learned more about participations than we ever thought we would want to know,” said Carson with an ironic chuckle.
National trends, local variations
Commercial real estate, not surprisingly, continues to be of concern in many markets. Kentucky’s Billie Wade said that pressured commercial landlords slashed pricing by as much as 25% to hold onto tenants, sometimes offering discounts before leases even expired.
The surplus of commercial space, he said, drives them to it. “They know that if they don’t do it, other landlords will,” said Wade.
In urban New Mexico markets, CRE likewise is taking a hit, according to Ron Wiser, president and CEO of Bank of the Southwest. The $150 million bank, headquartered in Roswell, chiefly does business in non-metropolitan areas and in those markets CRE is doing somewhat better.
“Loan demand is still steady in most of our areas,” said Wiser. There’s been some decline in consumer appetite for credit, and residential borrowing is down. “But commercially we’re doing OK,” he said. One factor that has helped with CRE performance is the use of federal guarantees from the Small Business Administration and U.S. Department of Agriculture.
In an economy like this, there’s usually at least a bit of the current major pain around for everyone, and Chicago certainly hasn’t been left out. Dane Cleven’s Community Savings Bank, which mostly specializes in residential mortgages, in a classical thrift model, has had its share of home-lending angst.
“We’re doing OK this year,” said Cleven in the late 2009 roundtable discussion. “We put a great deal of money aside for troubled debt restructuring and helped many of our customers get through tight spots. But we were well capitalized.”
Cleven, chairman, president, and CEO at the $409.2 million-assets thrift, said that, while residential is its specialty, that it does have one large customer involved in CRE.
“I know he’s having trouble,” said Cleven, but the bank is monitoring the underlying properties, and, “they’re still performing.”
Loan pricing realities
Pricing loans, especially commercial loans, for the risk they represent to the bank can be a difficult affair. In some markets, during the boom times, pricing higher than the competition wasn’t the best way to build market share. On the other hand, pricing too low could build share that wasn’t so good to have when the music stopped.
Even now, with credit generally tighter, in some markets sufficient competition remains that risk-based pricing continues to be a goal, rather than a reality. Kansan Frank Carson, for instance, finds competition for loans still sufficient to hold rates down somewhat.
“There are some good credits out there where I just can’t justify ‘rating up,’ because some components of their credit aren’t as good as others,” Carson explained. “I’d lose the deal.”
On the other hand, where there have been large bank mergers, commercial customers’ concerns about retaining their lines has changed the competitive balance.
Risk-based pricing techniques
Here’s a sample of the bankers’ free-ranging discussion about adopting risk-based pricing methods:
Steele: Up front, we decide what’s the minimum rate that we need on a loan, whether it’s a C&I, commercial real estate, small-business lending, mortgage, or consumer loan.
About a year ago we moved away from floors. I guess everybody had, based on competition. But our competition—including some large banks—started setting floors again about a year ago, too.
More specifically on risk-based pricing, we grade credits on a scale of one to eight. That determines the level of pricing for that credit. We also look at debt service coverage—in other words, this debt service coverage gets this floor, that debt service coverage gets that floor. And we start from there, with ten different spreads, up from the prime rate. Collateral is also taken into account.
We have come to be a prime-based bank, although nowadays there are no prime-rate loans out there.
Wiser: We’re just beginning to adopt this process. We set a benchmark for what we would like to see, on the commercial side. We don’t always achieve that benchmark. But we do set a floor for all of our loans, and we’ve been setting shorter amortization periods. On the consumer side we’ve used risk-based pricing for about three years. And this helps us price every consumer loan consistently.
Ferrell: On the commercial side we use a vendor’s pricing model. Our credit department sets a risk rating, and from there we have a formula that builds in the balances; duration of the loan; collateral; and other factors. These are then weighed against a return on equity hurdle. And if the return promises to fall within range of that hurdle, then we can move forward.
And it’s a pretty substantial hurdle. If an individual loan officer finds that the proposed loan is falling below that hurdle, then he’ll have to get the head of the department to sign off on the deal.
Regarding floors, we instituted floors, as have all the other banks that we compete against. You’re the exception if you don’t have one.
In general, pricing has come back in our markets. We don’t see as many banks competing against the product so we’re able to get somewhat better deals than we have in the past. And the vendor’s model [Jack Henry’s Margin Maximizer] works well for us.
We don’t use prime much on the commercial side—we do for consumer loans.
McClure: We’re at the beginning stages of adopting this. Our market is densely populated and there is a bank on every corner. Our mantra’s always been pretty simple: “Get as much as you can close!”
But we don’t go crazy. There isn’t enough price in the world to make me want some loans.
Wiser: We’re just beginning to adopt this process. We set a benchmark for what we would like to see, on the commercial side. We don’t always achieve that benchmark. But we do set a floor for all of our loans, and we’ve been setting shorter amortization periods. On the consumer side we’ve used risk-based pricing for about three years. And this helps us price every consumer loan consistently.
Wade: We use the same vendor’s package that Randy and Patti’s banks do. To be honest, I was somewhat dragged into it—I wasn’t so sure I believed in all the modeling. My big fear was that our lenders would automatically go to the bottom of the range the software presented.
We have had a lot of discussion in our loan committee about this. And we’ve tweaked it and become much more comfortable. I have come to believe that it results in more fairness to borrowers. I think we were overcharging some and undercharging some others, particularly when you put deposits into the formula, along with the usual risk-based factors.
In fact, one of the things I value about the overall approach is that it helps my lenders focus on deposits. Otherwise they go out there and just sell loans. Now they understand that they’ve got to try to get the deposit accounts too, because that’s going to drive the relationship pricing on the model. BJ
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0110/index.php?startid=8
Trackback(0)
|
TrackBack URI for this entry
Subscribe to this comment's feed
